Observations on Changes in the Ninth Circuit’s Second Altera Decision

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June 27, 2019

As we posted earlier here (with a link to the new decision), the Ninth Circuit issued a new decision in Altera after replacing the late Judge Reinhardt with Judge Graber on the panel. But the result was the same as the withdrawn July 2018 decision—the Ninth Circuit upheld the validity of Treasury’s cost-sharing regulation that requires taxpayers to include the cost of employee stock options under qualifying cost sharing arrangements (QCSAs). Today, we present some observations after comparing the majority and dissent in the new decision with those in the Ninth Circuit’s withdrawn decision.

In the new decision, Judge Thomas recycled much of the language and logic from his withdrawn opinion, and Judge O’Malley reused much of her original dissent. Although they are few, some changes in the two opinions are interesting and notable. Overall, the changes serve to sharpen the disagreements between the parties (and the disagreements between the majority and dissent) in ways that will focus the discussion in the likely event of a rehearing en banc petition (or possible petition for certiorari). We focus here on two aspects of the changes.

Was There a Transfer of Intangibles that Implicated the Commensurate-With-Income Language in the Second Sentence of Section 482?

The majority did not address this issue in its withdrawn opinion, so some background is in order. When Treasury proposed cost-sharing regulations that explicitly required related parties to include employee-stock-option costs in the pool of shared costs, commenters put forward evidence that unrelated parties do not share employee-stock-option costs. But Treasury did not heed those comments and ultimately determined that the arm’s-length standard would be met if the regulations required taxpayers in QCSAs to include the cost of employee stock options in the pool of shared costs, regardless of what a comparability analysis might show about whether unrelated parties share those costs. So in order to uphold the Treasury Regulations, the majority had to conclude that the arm’s-length standard under section 482 does not mandate the use of comparable transactions.

In reaching that conclusion, the majority relied on the history of section 482 and especially on the addition of the second sentence of section 482. That second sentence provides that “[i]n the case of any transfer (or license) of intangible property…, the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.” The majority held that the Congressional intent behind the addition of that language in 1986 is what made it reasonable for Treasury to conclude that it was permitted “to dispense with a comparable transaction analysis in the absence of actual comparable transactions.”

Was there a “transfer (or license) of intangible property” such that Treasury could invoke the commensurate-with-income language to justify dispensing with a comparable-transaction analysis? There was indeed a transfer of intangibles at the outset of the QCSA in this case; Altera transferred intangible property to its QCSA with its foreign subsidiary. But that initial transfer is unrelated to the disputed employee-stock-option costs. Those stock-option costs relate to subsequently developed intangibles, not to the value of the pre-existing intangibles that Altera initially contributed. Then-applicable Treasury Regulation § 1.482-7A(g)(2) required a buy-in payment only for “pre-existing intangibles.”

It is, then, wholly unclear how those employee-stock-option costs for as-yet undeveloped intangibles constitute a “transfer (or license) of intangible property” such that the commensurate-with-income language is implicated at all. The taxpayer argued—both in its initial and supplemental briefing—that by its own terms, the commensurate-with-income language is not implicated once a QCSA is in place and therefore that language is irrelevant to the dispute. The taxpayer reasoned that “no ‘transfer (or license)’ occurs when entities develop intangibles jointly” because jointly developed intangibles “are not transferred or licensed between the parties, but rather are owned upon their creation by each participant.”

The majority said little about this issue in its withdrawn opinion and did not address the taxpayer’s argument. In its new opinion, the majority addressed the argument and declared itself “unpersuaded.” It held that “[w]hen parties enter into a QCSA, they are transferring future distribution rights to intangibles, albeit intangibles that are yet to be developed.” The majority does not, however, explain how “intangibles that are yet to be developed” are “pre-existing intangible property” under Treas. Reg. § 1.482-7A(g)(2) or, perhaps more importantly, how such undeveloped future intangibles can constitute intangible assets at all under the words of the statute. Instead, the majority leaned on the language in the second sentence of section 482 providing that the commensurate-with-income standard applies to “any” transfer of intangible property, holding that “that phrasing is as broad as possible, and it cannot reasonably be read to exclude the transfers of expected intangible property.”

The dissent seized on whether there was any transfer of intangibles that implicated the commensurate-with-income language. The dissent stated that “[t]he plain text of the statute limits the application of the commensurate with income standard to only transfers or licenses of intangible property.” And it observed that there is a contradiction between the majority’s conclusion that QCSAs “constitute transfers of already existing property” and Treasury’s own characterization (in the very preamble of the disputed regulations) of QCSAs “as arrangements ‘for the development of high-profit intangibles,’” inferring that parties cannot transfer something that is not yet developed. The dissent concluded that Treasury’s failure to make “a finding that QCSAs constitute transfers of intangible property” should be, as a matter of review under the APA, fatal to Treasury’s cost-sharing regulations.

Has the Arm’s-Length Standard Historically Required a Comparable-Transaction Analysis?

The majority made several changes from its withdrawn opinion in its account of the history of the arm’s-length standard under section 482. The changes appear to be aimed at bolstering the majority’s conclusion that Treasury was justified in concluding that the arm’s-length standard does not necessitate a comparable-transaction analysis. These changes take a couple of forms.

First, the changes add justifications for the proposition that the arm’s-length standard has not always mandated a comparable-transaction analysis in all cases. The withdrawn opinion included some evidence for this historical account, recounting the Tax Court’s Seminole Flavor decision from 1945 (where the Tax Court “rejected a strict application of the arm’s length standard in favor of an inquiry into whether the allocation…was ‘fair and reasonable’”). In its new opinion, the majority added the observation that Treasury provided for an unspecified fourth method for pricing intangibles in its 1968 regulations. And the majority refined its discussion of the Ninth Circuit’s 1962 decision in Frank, still quoting the language from that opinion denying that “‘arm’s length bargaining’ is the sole criterion for applying” section 482 (as it did in the withdrawn opinion) but then adding the new assertion that the “central point” of Frank is that “the arm’s length standard based on comparable transactions was not the sole basis” for reallocating costs and income under section 482. (As the dissent pointed out, a later Ninth Circuit decision limited the holding in Frank to the complex circumstances in that case and noted that the parties in Frank had stipulated to apply a standard other than the arm’s-length standard.)

Second, the majority made changes to add a series of new and more sweeping assertions that under section 482, Treasury has always had the leeway to dispense with comparable-transaction analyses in deriving the correct arm’s-length price. For instance, as a rejoinder to the taxpayer’s argument that the arm’s-length standard requires a comparable-transaction analysis, the majority wrote that “historically the definition of the arm’s length standard has been a more fluid one” and that “courts for more than half a century have held that a comparable transaction analysis was not the exclusive methodology to be employed under the statute.” It added similarly broad historical statements elsewhere in the new opinion, all in service of concluding that Treasury acted reasonably in dispensing with a comparable-transaction analysis in its cost-sharing regulations: “[a]s demonstrated by nearly a century of interpreting § 482 and its precursor, the arm’s length standard is not necessarily confined to one methodology” (p. 33); “the arm’s length standard has historically been understood as more fluid than Altera suggests” (p. 41); and “[g]iven the long history of the application of other methods…Treasury’s understanding of its power to use methodologies other than a pure transactional comparability analysis was reasonable” (p. 49).

In one of the subtler but more interesting changes from the withdrawn opinion, the majority’s new opinion removed a single word. In its withdrawn opinion, the majority said that Treasury’s 1988 White Paper “signaled a dramatic shift in the interpretation of the arm’s length standard” by advancing the “basic arm’s length return method…that would apply only in the absence of comparable transactions….” (emphasis added). But consistent with its conclusion in the new opinion that “for most of the twentieth century the arm’s length standard explicitly permitted the use of flexible methodology,” the majority appears to have concluded that shift in the White Paper was not so “dramatic,” dropping that word altogether in its new opinion. (In this vein, the majority also removed its assertion in the withdrawn opinion that “[t]he novelty of the 1968 regulations was their focus on comparability.”)

The new dissenting opinion disputed the majority’s historical account, stating that the first sentence of section 482 “has always been viewed as requiring an arm’s length standard” and that before the 1986 amendment, the Ninth Circuit “believed that an arm’s length standard based on comparable transactions was the sole basis for allocating costs and income under the statute in all but the narrow circumstances outlined in Frank.” And the dissent observed that even with the 1986 addition of the commensurate-with-income language, “Congress left the first sentence of § 482—the sentence that undisputedly incorporates the arm’s length standard—intact,” thus requiring a comparable-transaction analysis everywhere that comparable transactions can be found. The dissent pointed out that the White Paper clarified that this was true “even in the context of transfers or licenses of intangible property,” quoting Treasury’s own statement in the White Paper that in that context the “‘intangible income must be allocated on the basis of comparable transactions if comparables exist.’”

Ninth Circuit Again Upholds Cost-Sharing Regulation in Altera

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June 7, 2019

The Ninth Circuit issued a new opinion in Altera today after having withdrawn its July 2018 opinion. But today’s opinion does not change the result—by a 2-1 vote, the Ninth Circuit upheld the validity of the Treasury Regulation under section 482 that requires taxpayers to include the cost of employee stock options in the pool of costs that must be shared in qualifying cost sharing arrangements. Judge Thomas again wrote the panel’s opinion, Judge O’Malley again dissented, and Judge Graber—who was added to the panel to replace the late Judge Reinhardt—voted with Judge Thomas.

Although it borrows heavily from the withdrawn opinion (indeed, much of the language remains similar if not the same), there are some notable differences between today’s opinion and the withdrawn opinion. We will post some observations after a more careful comparison.

The taxpayer may seek a rehearing of the decision by the full Ninth Circuit (which is likely after the success that another taxpayer had in the Ninth Circuit’s rehearing of a similar issue in Xilinx). A petition for rehearing would be due July 22.

Altera Ninth Circuit Opinion June 2019